Choices on the Housing Market - Market report may 2012 · trends: the productivity trend in construction and the real interest rate trend over time. The turbulence on housing markets

Choices on the Housing MarketMarket Report

May 2012

Titel: Choices on the Housing Market, Market Report, May 2012

Published by: Sweden’s National Housing Credit Guarantee Board (BKN)Author and contact person: Alexandra Leonhard, +46 (0)8-545 137 62Co-Author: Bengt Hansson, Sebastian JohanssonData gathering: Marie Rosberg

BKN’s Market Report May 2012 3

This report discusses the risks on the housing market. How great are they and do they change over time? An important housing choice that we all have to make is whether to rent or buy. Those who choose to buy their own home generally have a lower housing cost over time than those who rent, but they do have to bear a capital risk that a tenant does not. On the other hand, tenants bear the risk of rent increases.

In the long-run there is no reason to believe that housing costs will develop differently for owned and rented properties. There is no difference in cost between building houses bought by private individuals to live in and houses that are bought and owned by companies in order to let them. The building costs are in principle the same. It is certainly more expensive to build tenant-owned apartments than rental apartments in Sweden, but the difference is primarily the result of differences in the price of land and choice of materials than in the way in which production takes place. Nor can the financing costs of managing and letting residential property be expected to differ greatly from the costs faced by a home-owner. As long as the tenant and home-owner have jobs, they are both able to pay the rent or the interest to the bank, as applicable.

In the long-run, therefore, the average home-owner and tenant both bear the same risk in terms of housing costs. Even though, the risk may be very different in the short-run. It is the same factors that determine housing cost trends: the productivity trend in construction and the real interest rate trend over time.

The turbulence on housing markets around the world in the last decade demonstrates that there is a significant price risk involved in owning. In difficult times, when the labour market and economy are at their weakest, house prices also fall the most. In the worst-case scenario, the home-owner, who is often heavily in debt, not only loses his job but is also forced to sell his home at a loss and without being able to pay the whole of the mortgage back to the bank. We are talking about an individual who finds him or herself in a difficult situation, with a small income and a debt that it is difficult or impossible to repay and which is also linked to the individual and not to the residential property.

A tenant who is unable to pay his rent can, on the other

hand, leave his home debt-free. The landlord is able to look for a new tenant and if they cannot do so, the landlord, which is often a company, may enter into bankruptcy, in the worst-case scenario. The owner does not have to take the debt with him, however. It is the bank that bears a credit loss.

The home-owner bears a price risk and an interest rate risk in the medium term. This prompts us to ask what needs to be taken into consideration when deciding whether to rent or buy. This is about choosing between ownership, on the one hand, with a lower housing cost in the long-run and the risks and benefits involved in ownership, and on the other hand, the security of renting. The decision that an individual household makes depends on its preferences and on the size of the risks involved in ownership compared with living in a rented property. Those who rent bear a rent risk, but unlike those who own, a tenant does not need to worry about interest rates and house prices.

In the long-run, the risk of owning is no greater than that of renting, but in the short-run, there is an obvious difference in the risks.

In this report, we describe just how great the risks are. What is the housing risk – what should we consider? A residential property is both a consumer good and a capital asset. How volatile are house prices over time and how should we measure the price risk in a world with other assets, such as shares? How great are the returns on various assets and how much do the returns on these different assets vary in correlation with consumption trends?

The Swedish rental market is characterised by a lack of availability of rental apartments in many areas and a lot of households are forced to buy, even though they would not choose to own their own home if there were rental apartments available. Households which put themselves into debt and are forced to bear price risk and interest rate risk.

Buying a house brings a lot of different risks – and opportunities

Buying a house is the biggest investment most people ever make. According to basic investment theory, you should diversify your investments in order to spread the risk. Few households, however, have the means to buy a house and

BKN’s Market Report May 20124

then invest a similar amount in other assets in order to diversify their investments. This leads to many households being over-invested in property1 and therefore heavily exposed to a number of different risks relating to the property market, such as house prices falling. They are also exposed to risks relating to mortgage financing and income/work.

Cochrane (1997) describes the risks on the financial market and compares these with the toss of a coin2. The chance of it falling heads or tails are fifty-fifty; in other words the risk of losing on the first toss is high. But the more times you toss the coin, the greater the probability that the distribution between heads and tails will even itself out. In the same way, the risk of share investments reduces if you choose to hold them for a longer period rather than a short one. The risk of losing money on share investments therefore tends to reduce over time, according to Cochrane, and the same should apply to property investments. From a short-run perspective, however, the return can be low if the assets are overvalued. So we have chosen to examine how house prices have developed from a long-run perspective (principally 60 to 400 years) and from a more short-term perspective (30 years). We will also analyse the return on property investments, taking into account not only house price trends, but also the price of housing consumption, borrowing and mortgage rates. Housing consumption (also called implicit rent in theoretical literature and in the rest of this report) can be described as the cost of living in a home, regardless of whether it is rented out or you live there yourself.

House prices in a long-run perspective

In this section, we analyse house price movements over long periods of time in order to determine the probability of real house prices rising over time. The housing market, just like the tulip market or the stock market, has a tendency to create bubbles3. This is because those who are active in the market often have backward-looking expectations based on past performance, which means

1 See discussion in i) Englund. P., (2009) “Indexderivat som skydd mot bostads-prisrisker” [Index derivatives as protection against house price risks], Ekonomisk Debatt, volume 37, No. 4 and ii) M. Flavin and Yamashita, T., (2002), “Owner-occupied Housing and the Composition of the Household Portfolio”, American Economic Review, Vol. 92.

2 Cochrane, J. H., (1997), “Where is the market going? Uncertain facts and novel theories”, Economic Perspectives, Vol. XXI, Issue 6, Federal Reserve Bank of Chicago.

3 The classic example of a bubble is the tulip mania in the Netherlands of the 1630s.

that they believe prices will rise tomorrow because they rose yesterday. Bubbles are created when people believe that prices can only rise. On the housing market, estate agents often say that buying a house is the best investment a household can make. Oddly enough, these voices are not heard when prices fall, according to Akerlof and Shiller4. They have examined American house price bubbles and were able to identify a recurring theme of demand for land and houses increasing as a result of an increased number of inhabitants, causing house prices to rise strongly. The high house prices at the end of the 19th century are explained by population growth, thus increasing the demand for land. “Since the supply of land cannot be increased, it is natural for prices to rise”. In the mid-1950s, rising house prices were once again the result of there being few assets as secure and stable as property. “The population is increasing and so we will see a long-run positive trend in house prices”. The figure below illustrates the high prices at the end of the 19th century, which normalised at the beginning of the 20th century and fell dramatically between 1920 and 1925. Prices rose again after World War II and reached a plateau where they remained relatively stable until the financial deregulation of the 1980s. Figure 1 shows, however, that the argument of a trend for house prices to increase does not hold true for the period 1890-1995. The strong rise after 1995 can be explained neither by significant population growth nor increasing construction costs.

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Figure 1. Real house prices, construction costsand population in the USA

House prices, index 1890=100Construction costs, index 1979=100

Population (right axis)

Source: Robert J. Shiller’s webbsite5 and Macrobond

4 Akerlof, G. A., Shiller, J. R., (2009), Animal Spirits: How human psychology drives the economy, and why it matters for global capitalism, Princeton University Press.

5 http://www.econ.yale.edu/~shiller/data.htm


In order to further illustrate the long-run price trend of house prices, we have chosen to examine the so-called Herengracht price index produced by Dutch economist Eichholtz6. He has calculated the prices of houses along the Herengracht Canal in Amsterdam between 1628 and 1973. The houses on which construction commenced in 1612 were beautiful residences that were used solely as residential properties or offices and are therefore particularly suitable for the analysis of the long-run house-price trend. Purchase price data is available for 4,252 of the 5,583 sales that took place between 1628 and 1973. This has been used to create the so-called Herengracht price index. We further used the OECD’s price index for the Netherlands in order to calculate the real house price trend up to 2011, assuming that house prices along the canal developed in the same way as the aggregate level in the Netherlands.

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Figure 2. Herrengracht price index and population in the Netherlands

Herengracht price index, 1628=100Population (right axis)

Linear trend

Sources: Piet M.A. Eichholtz (1996), OECD and Macrobond

It is difficult to identify from figure 2 a long-run trend that should be clearly positive. We have added a trend line, which nevertheless shows a weak increase for the period as a whole. However, if we exclude the last 20 years, when prices rose very sharply, the trend is slightly negative. It can also be added that price increases and falls stretch over periods of up to 70 years, which means that a person born at the beginning of a price rise, like that which began in 1816, would see constantly rising prices on the Herengracht Canal in Amsterdam throughout their lifetime. For this person, the argument

6 Eichholtz, P. M.A., (1996), A Long Run House Price Index: The Herengracht Index, 1628-1973, University of Limburg, Maastricht and University of Amsterdam.

of course holds true that “buying a house is the best investment you can make”.

Real house price data in Sweden is available from 1955. Here too, we can see that house prices remain relatively stable right up to the end of the 1990s. 1986 saw the beginning of financial deregulation in Sweden and the diagram below shows that house prices began to rise at that exact moment. Prices then fell as a result of the Swedish property and financial crisis of 1992. Since 1996 they have risen again continuously. Building costs, adjusted for inflation, increase very slightly up to the end of the 1990s, after which they increase somewhat more rapidly. However, they do not rise at the same fast pace as house prices.

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Figure 3. Real House prices, building costs and population in Sweden

House prices, indexBuilding costs, index (FPI)

Population (right axis)

Sources: Statistics Sweden and Macrobond

Real prices compared with nominal prices

One reason why many people choose to consider buying a house to be a “good” investment is that in nominal terms, house prices almost always increase. This gives rise to “money illusion” where households are unable to differentiate between nominal and real prices. Households that have owned a house for a long time can remember the purchase price they paid. If one compares the nominal purchase price with the nominal value of the house today, it has probably increased considerably in value, but it is often the nominal value that has increased, which is then subject to inflation. Despite this, it often gives the impression that you have made a profit, thus creating the illusion that house prices always rise.


The value of mortgages falls when inflation is high

It should, however, not be forgotten that if you borrow money to buy a house, the value of the loan will also fall, as a result of unexpectedly high inflation. This provides an incentive to take on debt when inflation is high. For example, inflation reduced the real value of household loans in Sweden by almost 8 per cent per annum during the 1980s. This encourages a high loan-to-value ratio when buying a house. The problem, however, is that the value of houses can fall. The average house-buyer in 1989 saw the value of their property fall up to 1994. If they had a large mortgage, the household would then be sitting in a house that was worth less than the mortgage, which can be problematic in a country where mortgages are personal, households are heavily indebted and repayments are low (read more about this in the section on debt below). Currently, inflation has only reduced the value of mortgages by an average of 1.6 per cent per annum since 2000. The Riksbank’s inflation target is an average of 2 per cent, which means that inflation will not reduce the value of mortgages by more than 2 per cent per annum. This is less than the current nominal interest rate for households with variable-rate mortgages; in other words, the real interest rate is positive.

Method of evaluating house prices

The price of houses can rise and fall, just like the price of securities, art or raw materials. A popular method of valuing shares is the P/E ratio (share price/company’s earnings per share). The P/E ratio is used, among other things, to determine whether or not to invest in a share. A high P/E ratio may indicate the following:

1. The share is overvalued.2. The investment risk and risk premium are low.3. Expectations of large profits.4. Backward-looking expectations and bubble

approach.

Modern finance literature has established, however, that for a broad share index, a high P/E ratio indicates that the shares are overvalued7. Prices have a tendency to vary more than company profits, which develop at a more even pace. This method can be used for property investments by

7 See for example Cochrane, J. H., (2011), “Discount Rates”, AEA Presidential address, The Journal of Finance, Vol. LXVI, No. 4.

calculating the price/rent ratio8. If the house price is high relative to the rent, it can be said that the house is overvalued and that households will then choose to rent rather than buy a property9. Theoretically, this should lead to lower house prices, since demand for owner-occupied houses and tenant-owned apartments falls. To calculate the price/rent ratio for Sweden, we are using the price of owner-occupied houses and rent according to the OECD definition, which includes heating, water and other maintenance costs, as well as profit and administration increases for rental apartments. In Sweden, this corresponds to the rent for rental apartments.

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Figure 4. Price/rent ratio and rent growth in Sweden

Price/rent ratio (left axis) Annual change in rents*

*) 1991 Tax Reform, under which VAT was applied to construction, which led to a large increase in rents.

Source: OECD

The figure above shows that the price/rent ratio is at a historically high level, indicating overvalued houses, a low risk premium, expectations of rising house prices and a bubble scenario. The increase is mainly because the price has risen and not because rents have fallen. An often repeated argument is that you cannot compare house prices with rents in Sweden because we do not have free market rents10. In some areas, such as central Göteborg, Malmö or Stockholm, the rents for rental apartments are lower than the free market rent would have been. However, at an aggregate level for the whole of Sweden, this does not seem to be the case. If we compare rents

8 For more information see O. Weeken, (2004), “Asset Pricing and the Housing Market”, Bank of England Quarterly Bulletin, Spring 2004.

9 OECD, (2006), “Recent house price development: the role of fundamentals”, Economics department working papers, No. 475

10 Rents should be set on the basis of the utility value, although new builds are the exception to this rule.


indexed to 2005 in a number of OECD countries, we can clearly see that (excluding the tax reform of 1991-1992) rents in Sweden have not increased at a slower rate than those in the other countries.

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Figure 5. Rent growth in the OECD

FRDKNOSEUKDEUS

Sources: OECD Economic Outlook and own calculations

Regional property wealth and property prices

The price rises of recent years have been exceptional. In this section, we examine which geographical areas have experienced the strongest growth in property price and wealth in Sweden.

Figure 6 shows the real price trend for owner-occupied houses and tenant-owned apartments in the major conurbations and Sweden as a whole between 2005 and 2010. The Stockholm area has experienced the fastest increase in prices for owner-occupied houses, while the price of tenant-owned apartments has increased the most in Malmö, closely followed by Stockholm. Throughout, tenant-owned apartments have seen larger price rises than owner-occupied houses.

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Figure 6. Real house price change 2005-2010

Owner-occupieed houses Tenant-owned apartments

Sources: Statistics Sweden, Mäklarstatistik [Estate Agent Stat.] and own calculations

Houses do not just provide protection against the wind and weather for households, they are also their primary source of wealth. We have calculated the property wealth of households for the major conurbations and the rest of Sweden, divided into tenant-owned apartments and owner-occupied houses. The property wealth is the sum of the market value of all owned property, which means that demolition and new builds/conversion respectively reduce and increase the property wealth if prices remain the same. The black bars in Figure 7 clearly show that property prices are the main reason for the increase in household property wealth.

New builds, conversions and rapidly rising tenant-owned apartment prices have caused the property wealth associated with tenant-owned apartments to rise faster than for owner-occupied houses. Figure 7 shows that wealth in the form of tenant-owned apartments has increased most rapidly in Stockholm, by 74 per cent. Next comes Malmö with 69 per cent, followed by Göteborg with a figure of 63 per cent, with the rest of Sweden registering 34 per cent. The reason why property wealth associated with tenant-owned apartments increased more in Stockholm than in Malmö, despite stronger price rises in Malmö, is because there was a larger increase in the number of tenant-owned apartments in Stockholm. In addition to new builds, around 50,000 rental apartments were converted to tenant-owned apartments in Stockholm during the period. The figure is somewhat lower in Malmö and Göteborg, where almost 10,000 and 12,000 rental apartments respectively were converted to tenant-owned apartments.


Total wealth, as well as wealth in the form of owner- occupied houses, has increased the most in the Stockholm area. This is followed by Malmö, Göteborg and the rest of Sweden. What separates the major conurbations from the rest of the country is the increase in wealth for the owners of tenant-owned apartments.

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Figure 7. Price- and wealth growth 2005-2010

Owner-occupied houses Tenant-owned apartments TotalWealth growthPrice growth


Our calculations show that almost half of the total property wealth is located in major conurbations. It is primarily tenant-owned apartment wealth that is concentrated in the major conurbations, while most of the wealth in the rest of the country is in the form of owner- occupied houses. In 2010, 72 per cent of tenant-owned apartment wealth was in the major conurbations. Around 53 per cent was in Stockholm, with 11 per cent in Göteborg and 8 per cent in Malmö. The reverse is true with regard to owner-occupied houses, with 59 per cent of the wealth being located outside the major conurbations. The remaining 41 per cent was situated in the major conurbations, of which 22 per cent was in Stockholm, 12 per cent in Göteborg and 7 per cent in Malmö.

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Figure 8. Geographical distribution of housing wealth, 2010

Owner-occupied houses Tenant-owned apartments Total


The fact that the price rises and property wealth are concentrated in the major conurbations in general, and Stockholm in particular, may be problematic in the event of any fall in prices on the housing market. Glaeser, Gyourk and Saiz (2008) demonstrate that in those areas where prices rise the most in an upturn, they also fall the most in a downturn11. The fact that the majority of the property wealth is concentrated in the major conurbations means that households in these areas are particularly sensitive to price changes. The budgets of Stockholm households are particularly sensitive to lower tenant-owned apartment prices.

House prices and consumption

The economy is affected by house price fluctuations. A large proportion of household wealth (around 60 per cent in 2011) consists of property wealth12. If house prices were to fall, this would mean a reduction in household wealth, which has a negative impact on households’ willingness to consume and on economic growth. A number of empirical studies show that changes in wealth as a result of increased or reduced house prices have a negative impact on private consumption13. Case, Quigley and Shiller (2011) have examined how increased household wealth resulting from rising house prices

11 Glaeser, E. L., J. Gyourko and A. Saiz, (2008), “Housing supply and housing bubbles”, Journal of Urban Economics, Vol. 64(2), pages 198-217.

12 Statistics Sweden, and own calculations which exclude collective agreement pensions from household wealth.

13 BKN (2009), “Bostad, förmögenhet och konsumtion” [Housing, wealth and consumption], Marknadsrapport [Market Report], February 2009.


affects private consumption in America14. They found that a one per cent increase in property wealth leads to a 0.11 per cent increase in consumption. In contrast, a one per cent increase in financial wealth leads to a rise in consumption of only 0.05 per cent. Calomiris, Longhofer and Miles (2012) find a similar result when examining how the consumption of various households is affected by house price rises15. They reason that financial wealth varies to a greater extent than house price wealth and is considered to be transitory and therefore has less of an impact on consumption.

Without examining causality, the trends for house prices and private consumption show that these have correlated since the 1970s. The correlation in Sweden, Denmark and the USA is shown below. It further appears that the correlation has grown stronger in Sweden in recent years.

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Figure 9. Annual growth of private consumptionand house prices in Sweden 1971-2011

Consumption (left axis) House prices

Sources: OECD and Macrobond

14 Case, K. E., J. M. Quigley and R. J. Shiller, (2011), “Wealth effects revisited 1978-2009”, NBER Working Paper Series, No. 16848.

15 Calomiris, C. W., S. D. Longhofer and W. Miles (2012), “The housing wealth effect: the crucial role of demographics, wealth distribution and wealth shares”, NBER Working Paper Series, No. 17740.

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Figure 10. Annual growth of private consumption and house prices in Denmark 1971-2011

Consumption (left axis) House prices


House prices rose much faster than consumption in Denmark between 2004 and 2006, but in recent years, consumption has tracked house price movements quite closely. There is a similar pattern in the USA.

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Figure 11. Annual growth of private consumptionand house prices in the USA 1971-2011

Consumption (left axis)House prices (S&P/Case-Shiller index)


The correlation between consumption and house prices involves a great deal of risk, for both overall economic growth and individual households. The risk increases considerably if households are in debt.

Return on property investments

In the following section, we examine the risk and return on property investments. A property provides a service to


the owner, which the owner uses if he or she lives in the owner-occupied house or tenant-owned apartment. As a result, the return on a property investment consists partly of a housing service, often called implicit rent, D, and partly of a change in the price, P. In the calculations below, we assume that the property buyers do not have a mortgage. Nor do we include any taxation on possible capital gains. The return on property investment is calculated as follows16:

𝑅𝑅t = ��𝐷𝐷t

𝑃𝑃t�+ �

𝑃𝑃t +1

𝑃𝑃t− 1�� ∗ 100

Data from the OECD enables us to compare the return on property investments in a number of countries. The standard deviation and the average annual return on property investments are shown below17.

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Figure 12. Volatility and return on housing1980-2010

Annual return (see reference 17)Standard deviation on return

Source: OECD

The highest annual return was received by house-buyers in Spain18. However, standard deviation is also the highest here, which means that the risk is also the greatest.

16 With the qualification that the long-term rent/price ratio is 5 per cent between 1980 and 2000, when the housing markets were on average in equilibrium.

17 Annual return means the compounded average annual growth rate (CAGR) of the return, calculated as follows:

CAGR(t0, tn )=(A(tn)/A(t0))^(1/(tn-t0 ))-1Where A(t0) is the start value, A(tn) is the end value and the number of years is tn-t0.

18 Spanish house price statistics give the reserve prices for properties, which means that the fall in Spanish house prices has almost certainly been underestimated in the data from 2009 and 2010.

The return for property buyers has been between -6 and 33 per cent, with a probability of 95 per cent (+/-2 standard deviation). The second highest risk is in Denmark, where the return is much lower, but the confidence interval is between -8 and 28 per cent. In Germany, house prices have fallen in real terms since 1990. Implicit rents have, however, increased somewhat over the same period and as a result Germany has an annual property return of 7 per cent. Germany is also the only country where the confidence interval of 95 per cent extends across only positive figures; in other words, a property investment in Germany has, with the greatest probability (95 per cent), not generated a negative return over the period. In Sweden, the variation in the return on houses is significantly higher than in France for example, which has a slightly higher average return on property. This is because house prices have varied considerably more in Sweden than in France. The rent increases that took place in Sweden as a result of the tax reform had a significant impact on rents during the period 1991-93. If we exclude the period 1991-93, the standard deviation falls from 7.7 to 7, which is still higher than in France. In other words, the return on house purchases in Sweden has va-ried greatly. A property buyer has been able to expect, with a probability of 95 per cent, a return of between -5 and 25 per cent, which illustrates the uncertainty of the investment. We continue our analysis by examining the return for owner-occupied houses and for tenant-owned apartments.

In the absence of separate data on implicit rents for own homes and tenant-owned properties, we have taken as inspiration the method of Flavin and Yamashita19 to calculate the return on owner-occupied houses and tenant-owned apartments in order to determine which type of housing generated the greatest annual return between 1996 and 2011. They also take mortgage interest rates into account. Let implicit rent, D, which either the landlord or the person living in the house benefits from, be described as:

𝐷𝐷t = �𝑟𝑟t + d�𝑃𝑃t-1 + PTt

where r is the mortgage interest rate. We again assume that the property buyer is debt-free and wants to receive a return on the capital he/she has invested in the property instead of lending out the capital and generating profits by

19 Flavin, M. and T. Yamashita (2002), “Owner-occupied Housing and the Composition of the Household Portfolio”, American Economic Review, Vol. 92.


another way. In this example, we choose to use the mortgage interest rate to describe this opportunity cost. d stands for depreciation, i.e. how quickly the asset reduces in value20, and t stands for time. Property tax, or property duty, which replaced property tax in 2008, is indicated by PT. Property tax or duty will have a positive impact on rent, since it represents a cost for the landlord or property owner. The cost of ownership and maintenance, COM, is expressed as:

COMt = 𝑑𝑑Pt-1+ PT𝑡𝑡

Return on property, R, can be described using the formula above, as the change in price, implicit rent and cost of ownership, according to the equation below:

𝑅𝑅t =𝑃𝑃t +𝐷𝐷𝑡𝑡- COMt − 𝑃𝑃t−1

𝑃𝑃t−1

After a little simple adjustment, we can express the return on living in your own house, R, as follows21:

𝑅𝑅t =𝑃𝑃t + rt ∗ 𝑃𝑃t−1 − 𝑃𝑃t−1

𝑃𝑃t−1

As the real price neither rises nor falls in the long-run, the return, paradoxically enough, comprises the real mortgage interest rate in the long-run. The real mortgage interest rate for the period is shown along with the results in the table below. We have added the Stockholm Stock Exchange’s share index (SIXRX) in order to enable a comparison between the purchase of property and the purchase of shares. The study begins in 1995 because prices are only available for tenant-owned apartments from 1995 onwards. 1995 is the year when house prices were at their lowest, following the property and financial crisis of 1992. As a result, this analysis includes a 16-year price upturn for owner-occupied houses and tenant-owned apartments. Once again, the return is reported without including capital gains tax on either property or shares. The tax rate on property gains is 22 per cent22 and capital gains are taxed at 30 per cent in Sweden.

20 Here it is assumed that the cost of ownership and maintenance is equal to that of depreciation.

21 The tenant-owner does not pay property tax or duty, since this is borne by the tenant-owners’ society.

22 Capital gains tax was increased from 20 to 22 per cent on 1 January 2008.

Table 1, Real return on owner-occupied houses, tenant-owned apartments and shares 1996-2011

per cent Houses Apart-ments

Shares (SIXRX)

Real mortgage rate

1996 7,88 3,75 24,67 7,87

1997 12,11 23,00 48,71 5,78

1998 15,51 18,42 18,53 5,62

1999 13,07 21,06 18,52 4,36

2000 14,01 9,98 49,73 4,03

2001 8,91 14,29 -29,99 3,46

2002 7,58 5,34 -23,23 3,49

2003 7,45 12,15 -10,01 2,84

2004 11,51 15,43 31,38 2,30

2005 10,76 22,03 24,84 1,62

2006 9,80 20,92 28,17 1,49

2007 12,42 11,63 21,74 2,00

2008 -2,30 -5,39 -28,83 2,39

2009 7,12 7,96 -4,12 0,64

2010 5,66 9,76 33,05 0,56

2011 -1,12 -0,05 1,48 1,47

Annual return

8,72 12,14 8,85 Average: 3,12

Standard dev.

4,93 8,27 25,66

Soures: Macrobond, Mäklarstatistik[Estate Agent Stat.] and Statistics Sweden

Someone buying a tenant-owned apartment in 1995 received the highest return (almost 12 per cent per annum) on their investment. Both owner-occupied houses and tenant-owned apartments have generated a higher return than shares over the last 16 years and the risk of a negative return has been quite small. The confidence interval is between -4 and 29 per cent for tenant-owned apartments and -1 and 19 per cent for owner-occupied houses, while the risk on the share market has been considerably greater (between -43 and 60 per cent), particularly taking into account the relatively low average return on shares. Basing expectations on past performance, it would appear that tenant-owned apartments are where investments should be made. But what is there to say that the next 16 years will generate the same return? As we saw previously in the price/rent diagram, houses appear to be overvalued. In other words, those who bought a tenant-owned apartment in 1995 can be congratulated, as they have so


far received a good return on their investment that even beats the Stockholm Stock Exchange. Statistical analysis like the one above gives a good overview of the past trend, but it provides forecasters with little insight into how the future will look. What fundamental reason is there why returns on owner-occupied houses are lower than on tenant-owned apartments? What fundamental reason is there for real prices of owner-occupied houses and tenant-owned apartments to increase along the same trend? The long time series above show that there is no clear positive trend in real house prices. As can be seen from the high price/rent ratio, there is a great risk of falling real house prices and low returns. This will have a negative impact on consumption and as we saw previously, consumption is affected more by a change in property wealth than by a change in financial wealth.

Return on property investments with borrowing

Since most property owners have loans, it is important to understand what return investment in property will generate if the property owner has a loan secured on their home. But not least how the risk increases through borrowing and the so-called “leverage effect”. The return on a mortgaged property or share portfolio, RD, is described as the return on an unmortgaged property or share portfolio, R, (see calculation on p. 11), the mortgage interest rate, r, and the Debt/Equity of mortgaged properties using:

RDt = �Rt + (𝑅𝑅t − rt )Debtt

Equityt�

We assume that two-thirds of property owners have a mortgage secured against their owner occupied house or tenant-owned apartment (see next section). In the share portfolio, we assume that the shareholders have a loan-to-value ratio of 50 per cent and that they have secured this loan against their home and therefore pay the same rate of interest as for a mortgage. The highest annual average growth rate for the return is again achieved by mortgaged tenant-owned apartments.

Table 2, Real return on mortgaged owner-occupied hous-es, tenant-owned apartments and shares 1996-2011

per cent Houses w. mort.

Apartments w. mort.

Shares w. loans

1996 16,40 5,00 36,97

1997 24,37 28,76 73,04

1998 31,51 24,09 27,77

1999 25,32 28,30 27,76

2000 24,71 15,36 74,58

2001 13,51 21,68 -45,00

2002 11,19 8,44 -34,85

2003 11,46 19,28 -15,02

2004 23,35 28,88 47,06

2005 22,16 40,14 37,25

2006 18,19 35,53 42,25

2007 20,40 20,33 32,60

2008 -14,36 -14,39 -43,25

2009 19,16 24,19 -6,20

2010 9,49 22,62 49,57

2011 -14,79 -10,48 2,22

Annual return

14,21 18,52 10,79

Standard dev.

13,04 15,00 38,48

Sources: Macrobond, Mäklarstatistik[Estate Agent Stat] and Statistics Sweden

The return on houses and shares is almost the same, while the return on apartments is higher, as with the calculation without borrowing (see Table 1). It can be observed, however, that borrowing has led to a higher return on all investments. But this has come at a price. Namely that the risk also increases. The standard deviation for houses increases from just under 5 to 13, which broadens the confidence interval, thus increasing the risk of losing money on the investment. The same applies to tenant-owned apartments and shares. This illustrates the leverage effect which borrowing has on risk.

Increased debt and risk for households

Most households have mortgaged their property, which increases the expected return on owning and living, but also increases the risk. Compared with a diversified financial portfolio, property is high risk. Property is local and indivisible. If the local labour market weakens, the property will fall in value, while at the same time there is


a risk of the salary going unpaid. Furthermore, it is not possible to sell part of the property if so desired. The transaction cost of selling is high, unlike financial assets, which can be sold with a low transaction cost.

The size of a household’s mortgage therefore plays a major role in the risk of owning a home. The increasing debt of households is explained by the growth in mortgages. Mortgages account for 75 per cent of total household debt. The proportion of household debt that is not represented by a mortgage is increasing at the same rate as disposable income. The total of car loans, student loans and simple consumption loans amounts to around 40 per cent of disposable income and has done so since the beginning of the 1990s. The proportion of disposable income accounted for by mortgages has doubled over the last ten years and today represents 125 per cent of total disposable income. Total household debt is therefore 165 per cent of total disposable income.

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Figure 13. Household debt, share ofdisposable income

Mortgages Misc. Household debt Total debt Fore

cast

201

2

Sources: Statistics Sweden, National Institute of Econmic Research and own calculations

In order to understand what is driving the increased debt of households, we therefore need to understand what factors are driving mortgages. We have previously analysed household debt trends in various countries and a number, or rather combinations, of factors can be identified that lead to the rapid growth of mortgages23. Conditions on the credit market are important. Low interest rates, non-amortising loans, high maximum

23 BKN, (2011), “Hushållens skuldsättning i spåren av finanskrisen - en internationell jämförelse” [Household debt in the wake of the financial crisis – an international comparison], Marknadsrapport [Market report], February 2011.

permitted loan-to-value ratios and the short-run market valuation of properties with the ability to withdraw equity are factors that make it easy to borrow money. Combined with rising house prices, these circumstances often mean that we get the kind of price/mortgage spiral which has been observed both in Sweden and in other countries24.

Debts rise – repayments fall

The willingness of households to borrow has increased over time. This can be seen not only from the increase in the total mortgage stock but also in the fact that the proportion of households with a mortgage is increasing over time while the proportion of households repaying is falling. This is illustrated in tables 3a and 3b which are based on data from SEB’s House price barometer25 and Household Budget Survey (HBS) from Statistics Sweden26.

Table 3a.Share of households with mortgage (SEB House price barometer), per cent

Share w. mortgage Share w. mort. that amortise

All House Apart-ment


2006 66 74 47 72 77 53

2007 64 71 40 72 74 60

2008

2009 64 70 49 67 69 59

2010 67 72 48 66 68 54

2011 64 65 58 67 69 57

2012 72 75 58 64 68 46

Source: SEB House price barometer

The house price barometer shows that the proportion with a mortgage during 2006, 2007 and 2009 was 65 per cent, rising to 68 per cent during the period 2010-2012. The average proportion of households amortising for the corresponding periods is 70 per cent and 66 per cent respectively. The survey responses vary a great deal between individual years, but taking this into

24 BKN, (2011), “Kortsiktiga hushåll i riskzonen – lärdomar för framtiden” [Short-sighted households in the risk zone – lessons for the future], Marknadsrapport [Market report], October 2011.

25 SEB’s house price barometer is based on telephone interviews with 1,000 people carried out by Demoskop AB.

26 The information in SCB’s HBS is based on telephone interviews with the general public.


account, the interview responses indicate an unchanged or reduced willingness to amortise in 2012. Particularly remarkable is the large fall in willingness to amortise among tenant-owned apartment households.

Tabell 3b. Andel hushåll med lån, procent (SCB HEK)

Share w. mortgage Share w. mort. that amortise



2009 66 72 55 62 70 43

2010 68 76 57 62 68 45

Source: Statistics Sweden HBS

We only have HBS data on household debt and amortisation for the years 2009 and 2010. The proportion of households in debt increased slightly between 2009 and 2010, while the proportion repaying remained unchanged. Around two-thirds of households have loans and of these, 62 per cent are repaying them. There are no signs of an increase in willingness to repay.

50

55

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65

70

75

80

2005 2006 2007 2008 2009 2010 2011 2012

Per

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Figure 14. Share of households in debt that amortise

Source: SEB’s house price barometer

In order to assess the risk, it is useful to know what the situation is in different parts of the country. Generally speaking, people who live in cities are more likely to have a loan secured on their property than in the rest of Sweden. The table below shows that Stockholm has the largest proportion of households with loans, closely followed by Göteborg and then Malmö, with the rest of Sweden having the smallest proportion of households in debt. It also shows that a larger proportion of owners of single-family houses have a mortgage on their house than tenant-owned property owners, although the difference is not as great in Stockholm as it is in other cities and in the rest of Sweden.

It can be seen that not only is there a small proportion of mortgage holders who repay but also that repayments are low as a percentage of the mortgage loan stock. Apartment owners chose to repay 0.8 per cent of their mortgage debts in 2010; see table 4. House owners repay 1.4 per cent per annum and are therefore more inclined to repay than apartment owners. This means that repayment periods are longer – 70 years for owner-occupied houses and 125 years for tenant-owned apartments. The worst at repaying are apartments owners in Stockholm and Göteborg. In Stockholm only 36 per cent of apartment owners with debts repay and the repayment period is around 170 years. The corresponding figures for Göteborg are 40 per cent and 110 years. Best at repaying are house owners outside cities, where 73 per cent repay and the repayment period is 59 years.


Table 4. Geographic distribution of debt and amortisation, 2010

Per cent share of households:

w. mort.

w. mort. that amortise

Amor-tisation% of mort.

Sweden Apart-ment

57 45 0,8

House 76 68 1,4

Total 68 62 1,3

Stock-holm

Apart-ment

72 36 0,6

House 84 55 1,0

Total 76 45 0,8

Göteborg Apart-ment

67 40 0,7

House 82 60 1,0

Total 75 53 1,0

Malmö Apart-ment

59 45 0,9

House 80 62 1,1

Total 68 56 1,0

Rest of Sweden

Apart-ment

44 60 1,5

House 73 73 1,7

Total 64 71 1,7

Source: Statistics Sweden, HBS 2010

Property owners in Stockholm are the most indebted and are the most sensitive to the housing market. Stockholm has 35 per cent of all mortgages in the country, but only 25 per cent of the employment income, 22 per cent of the population and 20 per cent of the country’s tenant-owned properties and own homes. We can compare this with Göteborg, which has 11 per cent of the country’s mortgages, 10 per cent of the income, 10 per cent of the population and 9 per cent of all owned property. Or Malmö, which has 8 per cent of the mortgages and 7 per cent each of the income, population and owned property. Debts in the rest of Sweden are 46 per cent, or less than half of the total mortgage debt in the country. This should be compared with the fact that the lion’s share, 61 per cent, of Swedes live outside the three major cities, have 58 per cent of the income and almost two-thirds of all properties.

Table 5. Mortgage statistics in the major conurbations and Sweden, 2010

Per cent share of: Total mort.

Earned income

Popu-lation

Owned apartm.

Sweden Apart-ment

25 35

House 75 65

Total

Stockholm Apart-ment

16 12

House 19 8

Total 35 25 22 20

Göteborg Apart-ment

3 3

House 8 5

Total 11 10 10 9

Malmö Apart-ment

2 3

House 6 4

Total 8 7 7 7

Rest of Sweden

Apart-ment

5 16

House 41 48

Total 46 58 61 64

Source: Statistics Sweden, HBS 2010

Household mortgage debts are currently SEK 2,150 billion. Mortgages on owner-occupied houses amount to SEK 1,600 billion and on tenant-owned apartments are SEK 550 billion. Over the last decade, mortgages secured on houses have increased by 10 per cent per annum on average and mortgages as a whole have increased by 20 per cent per annum on average. Since mortgages have increased more rapidly than the value of houses, the loan-to-value ratio has increased over time and households’ equity has fallen in relation to debt. As can be seen in Figure 15, the trend has been increasing in the loan-to-value ratio, both for tenant-owned apartments and for single-family houses. Having historically had a very low loan-to-value ratio, tenant- owned apartments are now just as heavily mortgaged as houses.


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Figure 15. Loan to value

Owner-occupied housesTenant-owned apartments

Owned housing

Sources: Mäklarstatistik [Estate Agent Stat.] and Statistics Sweden

The actual loan-to-value ratio for the two-thirds of households with loans is on average higher than that shown in Figure 15. In Table 6, we report the average loan-to-value ratios for the major conurbations and the rest of Sweden in 2010, for all households as well as for only those households that are in debt. We have obtained data on the total mortgage debt divided into owner- occupied houses and tenant-owned apartments from financial market statistics. The distribution of debt by region is based on data from the HBS for 2010. Information about the number of houses and tenant-owned apartments also comes from Statistics Sweden and we have obtained details on average prices for homes from estate agent statistics. Loan-to-value ratios vary somewhat. Tenant-owned apartments and owner occupied houses in Stockholm are heavily mortgaged and home-owners in Stockholm are therefore sensitive to house price falls.

Mortgages have increased since 2010 but we have no data on regional trends after 2010. The increase for tenant-owned apartments is around 15 per cent since 2010 and for houses is 10 per cent. House prices in both Stockholm and Sweden as a whole have risen over the same period by around 5 per cent, while the prices of owner occupied houses have remained unchanged. A broad assessment would therefore be that the average loan-to-value ratio in Stockholm for tenant-owned apartments today is just over 60 per cent and for houses is just under 60 per cent. However, loan-to-value ratios are also relatively high in the rest of Sweden.

Table 6. Loan-to-value 2010, per cent

All households Households w. mortgage

Stockholm House 44 52

Apartment 41 57

Göteborg House 38 47

Apartment 32 48

Malmö House 40 50

Apartment 30 51

Övriga Sverige

House 35 48

Apartment 24 54

Source: Mäklarstatistik [Estate Agent Stat.] and Statistics Sweden

Rental apartments – a secure but more expen-sive way of living

Renting is an attractive form of living since tenants avoid the risks involved in owning. It may seem strange to talk about the risks of owning after many years of real increases in owner occupied house prices which have meant returns on tenant-owned apartments have been much better than on investments in the share market. It is difficult to calculate the return on rental apartments, however, in the same way as for tenant-owned apartments. Security and peace of mind are things that most people are looking for, but it is hard to put a value on what that is worth. A secure home provides predictability about future consumption ability. This means that consumption for households living in rental properties is not affected by property wealth reducing as a result of falling house prices in the same way as for households who own their property.

International studies show the importance of well- functioning housing markets for workforce mobility. It is obvious that people who live in rental properties are generally more mobile than those who own their own home27. Rental properties do not involve such high transaction costs, which makes it easier for people to move where the work is, benefiting the labour market, the

27 BKN, (2008), Samband mellan bostadsmarknad, arbetskraftens förlighet och tillväxt [Relationship between the housing market, a favourable labour market and growth], December 2008.


individual households and economic growth28.

The trend on the housing markets in those countries where house prices are falling illustrates the attraction of rental properties. In the USA, this trend is providing its own clear indications. In recent years, first-time buyers on the housing market have chosen to a greater extent to leave the ownership market and become tenants instead. The result has been that while house prices have been falling, there has been an obvious rise in rents because of a clear increase in demand for living in rental properties. The number of households renting increased by 700,000 per annum between 2006 and 2010, while the number of home-owner households fell by 200,000 per annum during the same period29.

The disadvantage of rental apartments is that under normal circumstances, they are more expensive to live in than owned properties. Tenants avoid the risk of owning and have to compensate the landlord for this. Tenants also have to pay the landlord for management and supervision. Rents do not remain constant over time, but vary; however, compared with the price of owned properties, the volatility of rents is minimal. How much rents vary depends on the market situation and the provisions of the tenancy agreement. Entirely free market rents are unusual. The high transaction costs associated with moving and rental conditions are governed both in contracts and in legislation in all countries. Over time, however, the rent is adjusted in line with the market situation.

Another difference is that people who own their own home have a direct influence over their home that tenants do not have. On the other hand, this is not as important if there is a large supply of diverse rental apartments.

The Swedish rental market is more strictly regulated than those in other countries. Rents are not set by the free market, not even over time. Rents today are lower than what many people are prepared to pay, primarily in the major cities. This is particularly true in Stockholm, where the difference in rents between the centre and the suburbs is also minimal, which means that the stock is

28 OECD (2011) also describes how important it is to have a well-functioning housing market that facilitates workforce mobility in Andrews, D., Sánchez, A. C. and Johansson, Å. (2011), “Housing markets and structural policy in OECD countries”, OECD Working Papers No. (2011)5.

29 The State of the Nation’ s Housing 2011, Joint Center for Housing Studies of Harvard University.

being poorly used. Taken over longer periods, however, the average real rent tracks landlords’ costs. A system with contractually regulated rents, like the Swedish system, means that when the rent is adjusted as a result of major renovations, this is often by large amounts, in order to maintain profitability. This means rapidly increasing costs for many people, resulting in a major strain on household finances. The costs of those who are forced to move as a result of large rent increases are high and a gradual increase in rent over time is preferable to large one-off rises.

The current Swedish system for setting rents forces many people to own when they would actually rather rent if the opportunity were available. In attractive locations, this is generally the only way of finding somewhere to live, at least in the major cities. At the same time, the system means that the stock of housing is poorly utilised. There is overconsumption of housing in central locations, as rents are artificially low. At the same time, there are people who would be prepared to pay a lot for a centrally located rental apartment.

Conclusion

Owning your own house has been a very profitable strategy for the last 16 years. Particularly if you bought a tenant-owned apartment in Malmö, Göteborg or Stockholm 16 years ago. We have shown, however, that real house prices do not develop in line with a long-term positive trend, as many people are inclined to believe in times of rising house prices. Data that provides long series for house prices shows that they may fluctuate over a number of years, but have a tendency to remain around the average. However, people’s tendency to have backward-looking expectations means that in times of rising prices, we completely forget that prices can actually fall. As previously mentioned, the return on tenant-owned apartments has been fantastic and the return on owner- occupied houses has been as good if not better than on shares, which is remarkable. There is a lot of evidence, however, to suggest that property is overvalued and the risk of low or negative future returns should be taken into account in the home-buyer’s calculations, particularly in those areas where prices have risen the most. The fact that house prices have risen so much over a long period does not mean that they will continue to do so, but rather indicates that prices are likely to fall. Households who work on the basis that property is a secure investment therefore risk being disappointed.

Swedish households are taking on increasing debt, as the level of mortgages grows. A heavily indebted household bears a greater risk than one with a low level of debt. The return on an average mortgaged property in Sweden is around double as unsecure as the return on a completely mortgage-free property. When the price trend is surprisingly positive, as it has been over the last 16 years, there is no problem, but when prices fall, the risk of a heavily mortgaged household losing equity increases, resulting in higher levels of saving and reduced consumption.

The trend for increased debt has not yet been broken, nor have there been any identifiable signs of an increased willingness to repay among households over the last two or three years – quite the opposite. It appears that the willingness to amortise has remained unchanged among house owners, while the willingness to amortise among apartment owners, on the other hand, has actually fallen over the last two to three years.

The proportion of house owners who are in debt is greater than the proportion of apartment owners. However, apartment owners who are in debt have a higher level of debt than house owners and are therefore also slightly more vulnerable. Historically, it has been unusual for apartment owners to be heavily in debt, but the situation has now clearly changed with the rapid rise in debt in recent years.

Debt levels vary in different parts of the country. There is no doubt that property owners in Stockholm are the most indebted and are the most sensitive to the housing market. Property owners in the rest of Sweden, on the other hand, have a level of debt that is the same or less than their share of income, population and the number of properties would indicate.

Property owners bear a significant wealth risk, since the prices that have risen the most also tend to fall the most. The need to borrow is particularly great among young people who want to enter the housing market and who have not yet been able to build up enough equity. Generally speaking, many of those households that are currently heavily mortgaged would be better off as tenants than as heavily indebted property owners. There are also many older home-owners with large unrealised gains on their property who would probably like to live in a rental property if there was a well-functioning rental market.

We therefore assume that there are a lot of people who currently own their property who would choose to rent if there were a better supply of rental properties than there is today.Renting your home is a way of living that considerably reduces the wealth risk. It is the more expensive alternative in the long run for comparable properties, since landlords require compensating for the costs of property management and risk.

Tenants are, of course, exposed to the risk of rent increases, but this risk is small on a well-functioning and well- balanced rental market. On a well-functioning market, rents track the costs of operation and maintenance over time. In other words, there is considerably less risk for tenants than for those who own their own home. Property owners have the opportunity to achieve a positive return on their investment, but also the risk of a negative one. We can see increased demand for rental properties in those countries where house prices have fallen as a result of the financial crisis.


About BKN

The Swedish National Housing Credit Guarantee Board, BKN, is a government agency under the Ministry of Health and Social Affairs. BKN plays two roles – a role as the government’s expert agency and a role as a market participant.

As an expert agency BKN monitors and analyses issues relating to housing finance, housing- and housing con-struction markets.

As a market participant BKN administers government credit guarantee programmes for housing development. BKN also gives support to reconstruction of housing companies that are owned by the municipality in weak housing markets, administers government support to municipalities who supply rent guarantees, and provide first-time-home-buyers with home purchase guarantees.

Box 531, S-371 23 Karlskrona, Sweden, Telephone +46 - (0)455-33 49 40, E-mail [email protected] www.bkn.se

Choices on the Housing Market - Market report may 2012 · trends: the productivity trend in construction and the real interest rate trend over time. The turbulence on housing markets

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